THIS ARTICLE IS SPONSORED BY THE MINNESOTA DAIRY HEALTH CONFERENCE.

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1 THIS ARTICLE IS SPONSORED BY THE MINNESOTA DAIRY HEALTH CONFERENCE. ST. PAUL, MINNESOTA UNITED STATES OF MINNESOTA

2 Increasing Profit on Dairy Farms: Strategies and Thoughts for Low Milk Prices John Fetrow VMD MBA! Steve Eicker DVM MS2 Steven Stewart DVM!!College of Veterinary Medicine, University of Minnesota, St. Paul, MN 2Valley Agricultural Software, King Ferry, NY The past year has been a challenge for most dairy farmers, the result of a dramatically decreased milk price. This economic climate intensifies the need for dairy veterinarians to do everything they can to help their clients make good management decisions that will preserve the health of their cows and assure the farm's economic survival. People facing tight financial situations often forget that the fundamentals of good business don't change. Good dairy management remains good dairy management. Cows must be healthy, be milked properly, be housed in a clean environment, and be provided ample balanced feed, clean water, and fresh air. Similarly, the financial aspects of operating a dairy business remain the same. The dairy should strive for high revenue (production), low expenses (buy inputs at the lowest possible cost and avoid spending on items that do not either contribute to revenue or reduce risk), minimize risks, and work to limit fixed assets per productive unit (cow). Marginal Milk As always, the last milk produced typically generates the most profit on a dairy. This marginal milk adds revenue at the same rate (the milk price), but costs less to produce because many fixed cost (including maintenance feed costs) are already covered. At the limit, the only costs of producing another 100 pounds of milk from 100 cows on a given day is the cost of the feed needed to support the additional milk production. For this reason, all dairies should be focused on increasing the dry matter intake of milking cows by whatever reasonable (and sometime unreasonable) means available to them. Table 1 demonstrates the power of additional dry matter intake and marginal milk production. At $11.50 per hundred pounds of milk (cwt) and typical feed prices, ifcows in a herd milking 100 cows each eat one pound of additional dry matter every day, the profit increase is approximately $8,000 per year or $80 per cow. The profit margin from this added milk is $8.72 per cwt! An average upper Midwest dairy farm will probably only earn a profit of $200 per cow in the current economic climate. An additional $80 per cow is an increase in profit of 40%, all from only one pound of increased dry matter intake and the resulting marginal milk production. Profitability Profitability of a dairy business can be measured in several ways: Total profit earned: obviously, this number is the most compelling measure of profit, since these are the real dollars in absolute terms that provide the dairyman with funds for 78

3 living. Total profit does not, however, effectively measure the efficiency of the business in generating profits. For example, a profit of$60,000 on a 50 cow dairy is remarkable; on a 1,000 cow dairy troubling. Return on assets (ROA): This is the best measure of the dairy's ability to extract profit from its total operation. It is the best measure of the farm's productive efficiency. Return on assets should be greater than the cost of borrowed money (e.g. greater than about 10 percent) so that the dairyman derives profit in excess of the expense of using the lender's money to capitalize the operation. When ROA is calculated, interest expense should be added back into profit. This adjusts for profitability of the operation independent of the source of capital and is a better measure of the farm's real operating profitability. Return on equity (ROE): This is the measure of the earning power of the dairyman's own money, invested in the business. Return on assets should be higher than other opportunities for investment intome the dairyman might have, assuming a comparable investment period and risk. The Dupont Equations: margin and volume The so-named "Dupont Equations" describe standard business relationships that explain the contributions of business operations to profit. To calculate the equations, a few definitions are needed: Profit margin: the proportion of revenue that is profit, i.e. profit / revenue This is the margin of profit on sales in most businesses. For dairies, sales mean all sources of revenue, mostly milk and cull cows. Capital turnover rate: revenue earned by the operation / farm assets. Capital turnover ratio is a measure of the business' ability to generate sales from the assets owned. One of the major challenges facing traditional small upper Midwest dairies is their low capital turnover ratio (relatively low revenues in proportion to large total assets per cow). Leverage: farm assets / farm equity This is a measure of the extent to which the farm finances its capital assets with borrowed money. Dupont equation: Return on assets: ROA = profit margin * capital turnover rate Profit/assets = profit / revenue * revenue / assets 79

4 Dupont equation: Return on equity: ROE = profit margin * capital turnover rate * leverage Profit/assets = profit / revenue * revenue / assets * assets / equity Understanding the relationships laid out in the Dupont equations is more than just a tidy exercise in algebra. The key understanding lies in recognizing that profit is a function of both margin and volume. For farms in the upper Midwest, too much emphasis has been placed on trying to reduce costs, assuming that the price of milk was a given and the only path to profit was to increase the margin by holding expense in check. Small dairies may be constrained by physical limitations from adding volume by adding cows, but few dairies are denied the chance to increase volume by increasing production per cow. Increasing production per cow often has a remarkable effect on the Dupont equations and profitability. Increasing production (marginal milk) dilutes out the costs of maintenance feed costs and fixed costs on the dairy, thus increasing the margin on milk sold. At the same time, increased milk per cow obviously increases volume produced. This improves return on assets, and assuming no additional equity is invested, return on equity. Table 2 illustrates this point for an increase in milk production with only an increase in expenses for feed fed. Using a herd milking 100 cows as an example, moving per cow production from 70 to 77 pounds per cow per day (a 10% increase) increases total profit by $18,644 dollars, a 62% increase in profit. ROA improves from 9% to 12.1 % and ROE improves from 8.6% to l3.9%. Note that in the example, not only did feed costs rise due to increased production, but the ration was assumed to increase by 2% for all feed consumed due to the addition of more expensive components. Despite this increase in cost for every mouthful consumed and a total increased annual feed expense of $1 0,739 (-$100 per milking cow!), the feed costs per cwt actually decrease (from $4.95 to $4.88) and income over feed costs (lofe) increases from $6.55/ cwt to $6.62. It can be difficult to explain to clients how the cost of every mouthful can go up, the total feed bill increase, and yet have average feed cost per hundredweight go down. Such is the power of marginal milk production. This kind of positive impact on a dairy's profitability can hold even if the improved production requires other inputs than feed. Table 3 shows an example where in addition to needing feed to support the 10% increased production, the dairy also had to invest in freestall conversions and additional operating expenses (bedding and labor). These added expenses reduced profit (now $12,505, "only" an increase in profits of 42%), but ROA and ROE are still significantly improved. ROA rises from 9% to 11 %, ROE from 8.6% to 12.1 percent. Improved production per cow is the dairy's most direct route to improved finances, both through improved margins and increased volume of production. Increasing volume Separate from the increase in volume from increased production per cow, many dairies have an opportunity to increase volume by increasing the number of cows milking. Every dairy 80

5 veterinarian has been in stanchion bams where stanchions are filled with dry cows or pre-fresh heifers, not milking cows. Freestalls are often not filled to capacity. Table 4 shows an example ofthe value of an additional cow added to existing facilities on a dairy. The profit contribution from adding 10 percent more milk by adding cows is not as great ($4,227) as from adding 10 percent to volume by increasing production per cow by bedding and feeding them better ($12,505). Assuming that the added cow does not reduce the production of any herd mate, the example show that the marginal cow can generate a profit of more than $400 per cow. The margin of profit per cwt of additional milk from an existing cow is not as great as additional milk production from an exiting cow, because the new cow brings other expenses with her in addition to feed costs. In the example, the profit margin is still more than $2.00 / cwt, far greater than most dairies receive on their average herd production at a milk price of $ Dairies should work very hard to assure that they are milking as many cows as possible through their facilities. The number of cows that maximizes profit defines the number of "slots" for milking cows on the dairy. With that goal in mind, dairies should also recognize that overcrowding facilities could ultimately reduce total milk production and profit. The goal is to find the right balance of herd inventory to maximize profit for the dairy. There are no formulas or rules that allow a dairy to determine this optimum stocking rate. It must be determined by experimentation on each dairy, and probably for each season. Once the optimum number of slots has been determined, the next step is to assure that each slot is filled with a cow that will maximize the profitability of the slot. Many dairies (ifnot nearly all) retain cows in milking cow slots that should be culled and replaced by a new heifer. Often this is done with the false goal of reducing culling, assuming that high culling rates are expensive. The goal of a culling program is not a low culling rate, but rather that each slot is filled with the cow that makes the most profit for the slot by being there. The profit in the slot depends not only on the current cow and her status and future, but also by the animals' futures that will replace her some day. Increasing margin at a given volume Finally, once the dairy is fully stocked by the optimal cows, attention can be directed at increasing the margin directly. The obvious first step is to seek to increase revenue per cwt, i.e. milk price. For most dairies in the upper Midwest, the first place to look is reducing somatic cell counts. Many herds lose as much as $100 per cow in lost premiums compared to a goal achieved by the best 10 percent of herds. Improved components (butterfat or protein) are another potential source of improved milk price, for example by correcting problems with fiber in the diet. Finally, forward contracting may offer possibilities for improving either milk price or at least stabilizing cash flow in the face oftoday's variable milk markets. The other side of the equation for margins is expenses. Obviously, it pays to shop for the best price. Time on the telephone comparing prices for major inputs can be very well spent. This is true regardless of the milk price situation. Other input price reduction strategies include volume purchases (taking care not to tie up too much cash), buying in cooperatives or groups, and forward contracting inputs. This latter strategy will likely become the norm in the dairy industry, just as it has become for swine or poultry. 81

6 It is perhaps useful to separate expenses on a dairy into two broad categories: 1) those that directly impact the cow in the near term and 2) those that don't. Approaches to expense reduction in times of low milk prices should be different for the two categories. Dairies should be ygy cautious about trying to reduce the expenses that directly impact cows, things like feed, bedding, veterinary services, BST, cow care and milking labor. Any reduction in these expenses (other than buying them more cheaply) should be monitored closely to be sure that the cows are not affected and production reduced. In some cases, the dairy should actually increase expenditures on these categories. Better care for the cows can increase production and reap the profit benefits of more marginal milk. In general, the most profitable farms are not the ones that write the smallest checks, but rather the ones that invest input dollars where they return the most profit. In times oflow milk prices, expenses that do not directly impact on the cow (new equipment purchases, painting the barn~ new land purchases, paving the driveway, building the young stock barn, etc.) can be postponed, canceled, or scaled back until economic conditions improve. Closing: The future for dairy farms belongs to those dairymen willing to approach their lives as professional businessmen. Doing so means understanding the business fundamentals that underlie dairy profitability. All dairies have opportunities to improve their profit potential if they deliberately approach the goal of increasing both margin and volume. 82